Posts Tagged ‘Bankruptcy’

I was looking at our blog’s stats and found a very strange search engine query that led to our blog – what does bankrupt country do. I read it, re-read it! Still clueless, I recollected a news item on TV that talked about Iceland’s financial crisis. The country fears it may go bankrupt.

Now, how would a country go bankrupt? The answer lies in an earlier post by Sankar. The banks of the country have assets (read liabilities under the current situation) that are 9 times in value to the country’s annual GDP of 16 billion euros. The Prime Minister of Iceland, Geir Haarde, in an address to the nation said that if these banks collapsed, the entire nation shall go bankrupt. The banks are not getting financial help from other international banks due to the development of a complete lack of confidence in business between the banks.

However, Russia has come to the rescue of the country with a 4 billion euro state loan to Iceland, this inspite its own banks ailing. Even a Swedish bank has provided a loan to a top Icelandic bank. The situation is still critical and Icelandic economy is still under a lot of pressure.


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How does one go Bankrupt!

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 Rs as there were only two pieces of 1 Rs coins circulating around.

1) There were 3 citizens living on this island country.  A owned the land. B and C each owned 1 Rs.

2) B decided to purchase the land from A for 1 Rs. So, now A and C own 1 Rs each while B owned a piece of land that is worth 1 Rs.

* The net asset of the country now = 3 Rs.

3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 Rs from A, and together with his own 1 Rs, he bought the land from B for 2 Rs.

* A has a loan to C of 1 Rs, so his net asset is 1 Rs.
* B sold his land and got 2 Rs, so his net asset is 2 Rs.
* C owned the piece of land worth 2 Rs but with his 1 Rs debt to A, his net residual asset is 1 Rs.
* Thus, the net asset of the country = 4 Rs.

4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 Rs loan to C. He then borrowed 2 Rs from B and acquired the land back from C for 3 Rs. The payment is by 2 Rs cash (which he borrowed) and cancellation of the 1 Rs loan to C. As a result, A now owned a piece of land that is worth 3 Rs. But since he owed B 2 Rs, his net asset is 1 Rs.

* B loaned 2 Rs to A. So his net asset is 2 Rs.
* C now has the 2 coins. His net asset is also 2 Rs.
* The net asset of the country = 5 Rs. A bubble is building up.

(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 Rs. The payment is by borrowing 2 Rs from C, and cancellation of his 2 Rs loan to A.

* As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 Rs.
* B owned a piece of land that is worth 4 Rs, but since he has a debt of 2 Rs with C, his net Asset is 2 Rs.
* C loaned 2 Rs to B, so his net asset is 2 Rs.

* The net asset of the country = 6 Rs; even though, the country has only one piece of land and 2 Rs in circulation.

(6) Everybody has made money and everybody felt happy and prosperous.

(7) One day an evil wind blew, and an evil thought came to C’s mind. “Hey, what if the land price stop going up, how could B repay my loan. There is only 2 Rs in circulation, and, I think after all the land that B owns is worth at most only 1 Rs, and no more.”

(8)  A also thought the same way.

(9) Nobody wanted to buy land anymore.

* So, in the end, A owns the 2 Rs coins, his net asset is 2 Rs.
* B owed C 2 Rs and the land he owned which he thought worth 4 Rs is now 1 Rs. So his net asset is only 1 Rs.
* C has a loan of 2 Rs to B. But it is a bad debt. Although his net asset is still 2 Rs, his Heart is palpitating.
* The net asset of the country = 3 Rs again.

(10) So, who has stolen the 3 Rs from the country ? Of course, before the bubble burst B thought his land was worth 4 Rs. Actually, right before the collapse, the net asset of the country was 6 Rs on paper. B’s net asset is still 2 Rs, his heart is palpitating.

(11) B had no choice but to declare bankruptcy. C as to relinquish his 2 Rs bad debt to B, but in return he acquired the land which is worth 1 Rs now.

* A owns the 2 coins, his net asset is 2 Rs.
* B is bankrupt, his net asset is 0 Rs. ( he lost everything )
* C got no choice but end up with a land worth only 1 Rs

* The net asset of the country = 3 Rs.

************ **End of the story; BUT ************ ********* ******

There is however a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting –

(1)    when a bubble is building up, the debt of individuals to one another in a country is also building up.
(2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island’s own currency. Hence, there is no net loss.
(3) An over-damped system is assumed when the bubble burst, meaning the land’s value did not go down to below 1 Rs.
(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a Rs or another piece of land but refrains from taking part in the game,  he will neither win nor lose. But he will see the value of his money or land go up and down like a see saw.
(6) When the bubble was in the growing phase, everybody made money.
(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A ) and take part in the game. But you must know when you should change everything back to cash.
(8) As in the case of land, the above phenomenon applies to stocks as well.
(9) The actual worth of land or stocks depends largely on psychology.

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